Friday, March 29, 2013

I'm starting to sell my position in bitcoin. I'll probably keep about 10% of my overall position but the rest will be repatriated back to the conventional fiat banking system.

Anyone who's been reading my bitcoin posts knows that I consider the fundamental value of bitcoin to be around zero. Consider what a bitcoin is. When you buy a bitcoin, you're basically securing a spot in a ledger. Bitcoin isn't actually a coin—it's just a key, a ticket, or an identifier, that indicates where in the ledger you sit. When people trade bitcoins among each other, what they're doing is swapping themselves into or out of that ledger. Space is limited. The amount of bitcoin in existence amounts to about 11 million, so there are only 11 million spots available.

Now there's nothing wrong with paying good money to secure a spot in a ledger. We've all done it before. When you buy an airline ticket you're basically buying room in an airline's ledger. The airline company carefully limits ledger space subject to its plane capacity. Your spot in the airline's records has a fundamental value. Come travel time, you can bring your ticket to the booth and redeem it for a real service—transportation. Would I buy a spot in an airline's ledger if I couldn't redeem my place in that ledger with air travel? Nope. It's not the spot in the airline's ledger that's valuable, it's the air time that the spot represents that's valuable.

Bitcoin is odd. Like an airline ticket, bitcoin is ledger space, but whereas a spot on an airline's ledger can be turned in for a real service, a spot on bitcoin's ledger can be turned in for, well, nothing. A bitcoin dangles in space, pointing at nothing. Despite its null value, bitcoin ledger space has been blessed by the market with a price of around ~$95, up from $11 just a few months ago. The market value of the entire ledger is moving in on $1 billion.

I would love to be able to create a ledger of my own and auction off space on it. Say I scratched out a 20x20 grid on a piece of paper and told the world that I had 400 spots to sell. A spot on my ledger would provide you, the potential owner, with no claim on my services whatsoever, but you'd be able to sell your spot in it to someone else whenever you wished. For me it would be free money, but I doubt any of you would bite. Why is it that people want to hold bitcoin space and not what I have to offer?

To begin with, bitcoin already has a positive value, giving it a huge advantage over spots in my grid, which don't. Second, the bitcoin ledger is an exceptionally cool ledger. Rather than my lame paper one, or an airline's centralized ledger, the bitcoin ledger is distributed. Hundreds of thousands of independent nodes all over the world store its data and work in a coordinated fashion to regularly update it. Bitcoin technology is fast and efficient. A user can instantaneously sell their spot in the ledger to someone on the other side of the world and, thanks to the architecture of the system, all parties to a transaction can be pretty sure that the spot being transferred isn't a fake or a counterfeit. Neat stuff, and people want to be part of it.

Despite these features, the fact remains that a bitcoin is little more than a spot on a ledger that points to nothing. It's dead-end, dangling ledger space. Without an anchor, bitcoin is free to rise 30% in two days, but likewise it can fall by more than that amount in an hour. Sure it's cool and edgy, but the waves of buyers who have moved into the bitcoin market because they like these attributes won't always be sufficient to prevent random shocks from knocking bitcoin's value down to nothing.

For instance, what happens when more ledger space enters the cryptocurrency market? This is already happening with the emergence of alt-chains like litecoin. But that's not the sort of ledger space I'm talking about. What happens when we bring in bitcoin-quality ledger space that has an anchor? I'm talking stable-value crypto-currency, not the sort that dangles and has a null value. These new alternatives will copy the best aspects of bitcoin, specifically its fast, efficient and safe record-keeping abilities. But rather than just providing blank tokens, they'll twin the ledger with some intrinsically valuable item.

Ripple, for instance, allows people to create and own IOUs, the transfer of which is recorded in the Ripple ledger. Or imagine if airline companies created standardized air time contracts and used a bitcoin-style record-keeping system to track trade in air time, leading to a new commodity money of sorts. In all cases—bitcoin, ripple, and air time—you get blazingly fast transaction speeds and low transactions costs. But with ripple and air time you're buying something real and stable, not just blank ledger space, whereas with bitcoin, you're still only buying a position in an empty ledger, with all the volatility that such emptiness entails.

A cascade-like process could ensue. As these stable-valued "ledgered" alternatives begin to steal cryptocurrency market share away from rudderless bitcoin, the price of bitcoin will deteriorate. This will only increase the rate at which people adopt alternatives, knocking bitcoin down further... and so on and so on to zero. Bitcoin could one day be like Friendster or Napster. These were the initial novelties that kick-started people's imaginations into creating new and ultimately superior versions of the original.

Of course, I could be dead wrong about all this. Bitcoin could rise to $1000 and will still be around in 10 years. If so, the tricky bit will be to re-conceive the the way I value assets and understand monetary phenomena. With that in mind, I'll keep a few bitcoins in my wallet. If I'm wrong, at least I'll be able to show some profits to balance things out.

Tuesday, March 26, 2013

Like Guntram Wolff over at the Bruegel blog, I hope that the much-rumoured capital controls on Cypriot deposits don't get enacted. So far the Euro authorities seem to have done everything right, albeit in a slow and circuitous manner. Insolvent banks are being closed, uninsured depositors, unsecured creditors, and shareholders are being bailed in, and solvent banks are slated to reopen.

Wolff's main concern is that capital controls threaten the very meaning of a monetary union:

With capital restrictions, the value of a euro in Cyprus is no longer worth the same as a euro held by any other bank in the eurozone. A euro in Nicosia cannot be used to buy goods in Frankfurt without limits. Effectively, it means that a Cypriot euro is not a euro any more.

Enact capital controls and we'd see the emergence of an entirely new currency trading pair CYP€:onshore€, with Cypriot euros trading at a discount. The discount would emerge since the ability of CYP€ to buy things outside of the island of Cyprus is limited. It would be a less liquid euro than "mainland" euro, and therefore would get penalized with a liquidity discount.

A Eurosystem in which euros are heterogeneous would technically be workable. For an analogy, look at China. The Chinese yuan has several different prices. Mainland yuan (CNY) typically trades at a discount to yuan in Hong Kong(CNH) and yuan in Taiwan (CNT). I've cribbed a chart below that shows the spread. Chinese capital restrictions prevent arbitrage forces from reducing the gap. Foreigners would prefer to buy cheaper CNY than more expensive CNH and CNT, but they can't because restrictions on capital inflows into China prevent them from doing so. Chinese companies would like to borrow in Hong Kong rather than China since they'd be borrowing high-value CNH and repatriating it, thereby lowering their cost of funding. But capital outflows are also limited.*

Just like capital controls prevent the closing of the CNY-CNH spread, the introduction of European capital controls would lead to the emergence of the CYP€-€ spread. What are the dangers of Europe adopting a Chinese model of multiple prices for the same currency?

As Wolff points out, the Eurosystem already has a tool to deal with flight from banks: the ECB's incredibly powerful Target2 clearing system. When Cypriot banks reopen and depositors start to transfer deposits to Germany, Target2 will accommodate these flows by stepping between the two banking systems, simultaneously acting as a creditor to Cyprus and a debtor to Germany. Like any lender of last resort, Target2 will be vigorous in lending, providing whatever assistance is required to Cypriot banks facing liquidity shortfalls.**

The great thing about Target2 is that its mere presence has the ability to prevent a bank run from ever being kick-started. If Cypriot depositors know at the outset that the incredibly powerful Target2 will accommodate their fears, why should they be fearful? Target2 is like Chuck Norris, as Nick Rowe and Lars Christensen would say. Its mere presence is enough to create powerful self-fulfilling counter-effects.

Cyprus wants to soften potential deposit flight with capital controls rather than leaving Target2 to do all the work. One wonders if these controls would help at all. Controls are porous, and investors will find cunning ways to get around them.

Worse is the precedent this sets. If capital controls are used as a substitute for Target2, the Euro risks losing a major stabilizing force come the next crisis. Say that it is 2016 and doubts spring up concerning Finland's banking system. If Finnish depositors know that Target2 will accommodate all deposit outflows from solvent Finnish banks, then they realize that they have nothing to fear, and the panic will subside on its own accord. But if Finnish depositors think that Cyprus-style capital controls will be put in place to prevent deposit outflows, the panic will only be exacerbated as people try to withdraw money from Finland before capital controls cause FIN€ to trade at a discount. Anyone who gets through the gate before it closes can't lose, so everyone tries to get through the gate. This effect is perverse, since the very rumour of capital controls leads to their actual adoption. With capital controls, a European bank panic is self-fulfilling—with Target2, that same panic is self-correcting.

Leave Target2 free to be the regulator of European liquidity flows—don't use capital controls. Haven't we already learnt this lesson? It was Draghi's speech about Euro convertibility from last summer that helped reduce yield spreads and stop the intra-European bank run. Gavyn Davies read that speech as a reaffirmation of unlimited Target2 power, and so did I.*** Never shackle Target2.
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* The Chinese are moving to less capital controls. Spreads are already declining, and at some point the CNY-CNH/CNT differential will be no more. ** The provision of these LOLR services is subject to Cypriot banks providing collateral. But the winding up of insolvent Cypriot banks and the haircutting of depositors *should* have insured that the remaining quantity of Cypriot banking liabilities have been pruned so that they equal the quantity of remaining collateral.*** See this comment as well as my first Never Shackle Target2 post.

Saturday, March 23, 2013

Exogenous/endogenous money, reflux, hot potato money, helicopter money, inelastic vs elastic currency. These are all part of the colourful lexicon developed by monetary economists over the centuries to outline a general set of problems: how does money get emitted from source, and when, if at all, does it return to source?

We usually describe money as exogenous, hot potato, helicopter, or inelastic if it is emitted at the initiative of the issuer, and the issuer doesn't allow the public to exercise any initiative in returning this money back to source. Once it has been air-dropped into circulation from a helicopter, this kind of money becomes immortal, passing like a hot potato from person to person forever.

We describe money as elastic or endogenous when the money-using public exercises its own initiative in both drawing money out from an issuing source and pushing (refluxing) this money back to the source. This sort of money never strays far from its issuer, snapping back like a rubber band to be destroyed when it is no longer wanted. Rather than being a hot-potato zombie, elastic money lives fast and dies young.

There's a big debate among monetary economics about whether money is exogenous/hot potato/helicopter/elastic inelastic or if it is endogenous/elastic/refluxible. This debate goes all the way back to the banking-currency school battle of the early 1800s. Currency school advocates wanted to limit the note issuing power of private banks in order to prevent the overissue of notes, whereas members of the banking school believed such regulation unnecessary since in a competitive banking system, unwanted notes would simply reflux back to the issuer. The currency school won that debate, but the war continues.

I find it helpful to skirt around the skirmish and re-orientate the debate around finance, not monetary economics. This means that we've got to translate the language of monetary economists—hot potatoes, exogenous/endogenous, reflux, and the like—into the lexicon of financial instruments.

Let's head over to the stock market first. I'm going to hypothesize that the common stock is a thoroughly exogenous financial instrument. A firm decides when to issue new stock and at what price. Once stock has been issued, there's no way for an investor to automatically return the stock to the issuer. Stock wanders zombie-like through the financial world until the issuing firm is wound up, if ever. General Electric's original 1000 shares, for instance, have been hot-potatoing through financial markets since June 23, 1892.

Also found on stock markets are exchange-traded funds, or ETFs. Unlike stocks, though, I would say that ETFs are thoroughly endogenous financial instruments. Take the SPDR Gold Trust ETF. When investor demand for the Gold Trust heats up, ETF units will trade at a premium to their implied gold value. Large authorized-participants buy units from the ETF originator at par, paying with gold, and then sell these blocks to the public until the premium has disappeared. Vice versa when GLD units are at a discount to their real gold value. Now the authorized-participants buy units from the public at a depressed price and sell them to the ETF originator at par for gold. The result is that the quantity of outstanding units fluctuates quite widely, as the chart shows, but the price, specifically the premium/discount, stays constant. The public, through the intermediation of authorized-participants, sucks out whatever quantity of ETF units from the issuer that it desires, and then refluxes unwanted units back to it.

Unlike ETFs, bonds are exogenous financial instruments. Firms issue bonds when they need funding and these instruments stay outstanding until redemption date or firm instigated early-retirement. Until then, bonds pass hot potato-like from hand to hand in the secondary market.

Not all bonds are like this though. A retractible bond, or retractible debenture, is a different beast. Investors can choose to exercise the retractibility feature of this species of bond and force its issuer to buy it back. If we break down a retractable bond into its parts we see that it is a bond with an embedded put option. The put allows investors take the initiative and "reflux" the bond back to the issuer.

Retractability, or puttability, is a feature that gets often gets added to preferred shares and sometimes even common stock. The interesting thing about retractibility and puttability is that it turns what was once an exogenous hot potato asset into a semi-endogenous instrument. While investors can not "pull" retractible bonds or puttable stock out of an issuer, they can easily push, or "put", already-issued retractibles back to the issuer when those instruments are no longer desired.

How can we turn our semi-endogenous retractible bond or puttable share into a fully endogenous instrument? Let's consider another financial instrument, the gift card. Indigo, a bookstore up here in Canada, allows consumers to buy any quantity of gift certificates at the till. These gift certificates are puttable—their owner can immediately return the card for redemption. That the public can take the initiative in both buying unlimited amounts of gift cards and returning those coupons whenever they want qualifies them as fully endogenous. Not only is the "discount window"* for endogenous instruments like puttable gift certificates and ETF units always open, there is also a well-defined rule for pricing the emission of new units. Retractible bonds, which already have the put feature, would qualify as fully endogenous if their issuer were to set up a "window" with a set of rules so that investors could draw out new bonds on their own accord.**

Because endogenous and exogenous instruments are structured differently, they act in peculiar ways when market conditions change. When the demand for an exogenous instrument like GE stock increases, its price will quickly rise to meet that demand while its quantity stays fixed. When demand falls, the only way for investors to rid themselves of GE is to bid its price down until it reaches a real value at which the market willingly holds it. Things work differently with endogenous instruments. When the demand for an endogenous instrument like a coupon or gift certificate increases, its quantity quickly rises whereas its price stays fixed. When demand falls, investors can exercise their put option and send them back to their issuer. In sum, prices do all the work in exogenous adjustment whereas quantities do all the work with endogenous adjustment. Exogenous issuers can choose the quantity of their issue, but not the price, whereas endogenous issuers can choose the price but not the quantity.

So back to the great debate. Is money endogenous or exogenous? If money is defined as a certain narrow set of financial instruments (cash + deposits, M1, M2, whatever) then we need to appraise each instrument's structure to see whether its issuer provides an associated discount window and embeds a put option—or not. A quick glance through the instruments found on the narrowest lists of money (say M1) shows that almost all of these instruments have embedded put options and discount windows, so narrow money is primarily endogenous.

This is different from a few centuries ago when gold and silver constituted a significant share of the narrow money supply. Since the only way to get rid of an ounce of metal is to pass it on, gold, like stock, is exogenous and immortal, with the very same gold coin once used 5000 years ago still circulating today, though perhaps in bar form. Modern monetary economists are beginning to add exogenous assets like t-bills, bonds, and other AAA-rated debt securities to the list of money since these assets can be easily collateralized. In doing so, economists are slowly returning to a world in which a larger percentage of the assets on the list of money are exogenous.***

And finally, there's the moneyness, or liquidity, view. From this perspective, there is no limited list of money-items. Rather, all assets provide varying degrees of money-services. Put differently, moneyness is a vector which spans all assets. Because it inheres to a degree in all assets, moneyness is both endogenous and exogenous. After all, the universe of assets is comprised of both types of assets. A change in the demand for liquidity/moneyness results in a complex shift in prices and quantities. Liquid endogenous instruments are drawn out of issuers and less-liquid endogenous instruments refluxed back to issuers. Liquid exogenous instruments rise in price while less liquid exogenous instruments fall in price.
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*In modern days, the discount window refers to a central bank's ability to lend. In the old days, banks had actual "windows" behind which stood a bank officer who would accept securities in return for bank deposits or cash. A "discount" to its market value was applied to the securities, a sort of haircut that also provided the banks with income. See this image from the Philly Fed.

**A bank deposit is the quintessential endogenous instrument. There are multiple windows for buying a deposit -- one can either sell cash to get deposits, or sell personal IOU to get them, with each window offering different rules and rates. When deposits are no longer needed, one can "put" them back at any point by requesting cash or a return of one's personal IOU.***With the emergence of Bitcoin, Ripple XRPs, and the other alt-currencies, we're seeing the return of exogenous monies with a vengeance.

Note: For more on reflux, I'd definitely recommend Mike Sproul's The Law of Reflux. For more on exogenous money, Nick Rowe is who you should be reading.

Thursday, March 21, 2013

Ok, readers. Here's a chance for you to flex your muscles. The following chart shows various short-term interest rates:

Why are these rates all so different? Can the differentials between them be arbitraged away? What sorts of institutional rigidities might be preventing arbitrage? For instance, we know certain institutions like Fannie Mae and Freddie Mac can't get interest on reserves held at the Fed. What other sorts of fine details might be important?
Or are the differentials between these various rates not currently open to arbitrage? Can they be explained by term risk? How much do other sorts of risk, like liquidity risk, counterparty risk, default risk etc drive spreads? A few specific questions:

a) The DTCC Treasury General Financial Collateral (GCF) repo rate used to trade at or below the fed funds rate. The Treasury GCF repo rate is a collateralized rate. Since collateral reduces risk, it makes sense it would trade below the fed funds rate. But why is the riskier rate now below the safer rate?

b) Why does the Fed funds rate generally trade above the t-bill rate? There's presumably less term risk in the FF rate, which would imply a lower Fed funds rate. Does interbank risk account for the higher fed funds rate?

c) Is it a risk-free trade to fund oneself in the fed funds market and invest the proceeds overnight at the interest rate?

d) Why would banks hold t-bills at all if they can simply keep reserves at the Fed for a superior return of 0.25%? The credit risk seems similiar: as a bank, you're exposed to the Fed in the case of reserves, and the Treasury in the case of bills.

e) Sometimes the 4-week t-bill yield crosses over the 3-month. Why? The credit risk is the same, and presumably bills are equally liquid. Are these inversions purely related to expected changes in yields?

Data, ideas, links,etc all much appreciated. I'm sure I'll have more questions in the comments, or if you have other interesting observations, go for it.

[Update 22/03/2013: I reinputted the Treasury GCF rate since my original data was off]

Tuesday, March 19, 2013

Cullen Roche penned an article on moneyness last week. In it he hypothesized that bank deposits are more money-like than paper dollars. In this post I'm going to highlight some thorny problems in ranking moneyness. I'll get back to Cullen's observation at the end.

If an observer wants to rank items by their moneyness, or liquidity, they might choose to begin the task by evaluating data like bid-ask spreads and frequency distributions of various assets in trade. Assets with low spreads and high frequencies might appear near the top of the observer's moneyness list, and those with high spreads and low frequencies might appear at the bottom. But spreads and frequencies are the objective liquidity data of markets. What we want to know is how the market experiences and digests this objective data on the way to building its own unique moneyness ranking of assets. Moneyness, after all, is subjective.

The best way to find out what the market actually thinks about something is to see how it prices it. If we can strip out the value of all the other services provided by an asset, all that remains is the value that the market puts on an asset's moneyness. Once we have this price, we can proceed to rank each asset according to its moneyness.

While market prices are surely the best way to build moneyness rankings, the problem is that markets rarely provide the prices to facilitate the analysis. Most markets are all-or-none markets, meaning that traders have to buy an entire asset and all the services it provides. There is no independent moneyness market in which an asset's liquidity services can be sliced away from all the other services, thereby allowing those liquidity services to be bought, sold, and priced.

When markets reveal moneyness rankings

Despite the lack of an independent moneyness market, from time to time markets do give us accurate snapshots of relative moneyness. One case in which we can get an unambiguous ranking is in comparing the prices of a bank's savings deposits to its chequing deposits. From the point of view of a potential owner, the two instruments are similar along almost all axes. Chequing and savings deposits are liabilities of the same issuer, so their credit risk is identical. They are both perpetual debt instruments convertible on demand, so their term risk is identical. Finally, they are convertible into the same underlying asset, paper dollars, so their expected change in purchasing power is exactly the same.

Yet the two instruments have very different market prices. A savings deposit currently yields a return to its holder of around 1% a year whereas a chequing deposit costs its holder around 1% a year in fees.

This variation in return structures arises from the one set of properties that differentiates a savings deposit from a chequing deposit: the range of transactional services attached to each one. Chequing deposits offer more options. In Canada, for instance, we are limited in using savings deposits to pay bills, write cheques, or make debit card transactions.

Since the difference in returns between the two deposit types comes to ~2% a year, the marginal depositor is effectively placing a premium of 2% on the extra bit of services provided by a chequing account. Put differently, given a $100 investment, a marginal depositor is willing to lose $1 in chequing account fees and forego $1 in savings account interest in order to enjoy the superior monetary services of a chequing account. Chequing account moneyness is worth $2 per $100 on the margin—so says the market.

Another unambiguous example of the market providing a moneyness ranking comes from the stock market. While my old post on this topic goes into the topic in considerable depth, I'll give a quick recap. A certain company that trades on the Toronto Stock Exchange has issued two classes of shares, RET and RET-A. Like the chequing/savings account example, both shares have the same credit risk—they are ranked pari passu and pay the same dividend. Despite these similarities, RET-A shares have almost always traded at a premium to RET, as is currently the case. RET-A yields 7.46% whereas RET yields 7.58%, a difference of 0.12%. Why not just invest in lower-priced RET and enjoy an excess return of 0.12%?

The best explanation for the difference in yields is the varying liquidity of each share. As I pointed out in my old post, there is very little activity in RET. As such, RET's bid-ask spread is wider than the RET-A's spread. Investors are willing to forego RET's 0.12% extra return in return for the enjoyment of the superior monetary services of RET-A, which arise from its low bid-ask spreads and active market. This is an unambiguous market signal of moneyness ranking.

Difficulty of using relative yields to rank assets by moneyness
Ranking the moneyness of assets is difficult to do when we compare across different asset classes and issuers. For instance, 4-week treasury bills currently yield around 0.10%, far below the 0.25% yield on deposits held at the Federal Reserve. Stephen Williamson thinks that this gap can be explained by the fact that t-bills are more liquid than deposits held at the Federal Reserve. After all, you can use t-bills as collateral for repo, but you can't use Fed deposits as collateral.

Confusing matters somewhat is that unlike the savings/chequing deposits and RET/RET-A examples, deposits and t-bills have different issuers. The Federal Reserve issues deposits whereas the US Treasury issues t-bills. We often assume that these institutions are effectively consolidated, and therefore carry the same credit risk, but there is no guarantee that this must be the case. As I pointed out in this post, a central bank can be left flapping in the wind by an irresponsible parent government. The two instruments also have different terms and payout structures. T-bills mature after four weeks whereas reserves are perpetual instruments convertible into dollars on demand. The upshot is that the reason for the yield gap between these two instruments is difficult to determine since differing credit risk, term risk, and moneyness might all be reasonable explanations. Without more data, we can't rank these assets according to moneyness.

The same goes for Cullen's point about the superior moneyness of bank deposits relative to paper dollars. While Cullen could very well be right, only evidence in the form of market prices would be sufficient to verify his claim. Let's say a deposit yields 0.25% whereas paper, as always, yields 0%. It would be tempting to say that paper is more moneylike, since it compensates for its 0% return by providing superior monetary services.

Muddying the waters is the fact that both a bank deposit and a paper note have different issuers, and therefore possess unequal credit risks. After all, there's no guarantee that a bank deposit will always be worth the value of its underlying paper, as the Cyprus case shows us. Thus, if a deposit yields more than zero-yielding paper money, this could be due to a deposit's higher credit risk, not the superior moneyness of paper. Further complicating matters is that paper notes burden their holder with an extra set of costs, namely the risk of loss and theft. If a deposit yields less than a zero-yielding paper notes, this premium could be due to either a deposit's superior moneyness or the awkwardness of paper notes. Because we can never be sure which effect dominates, we can't definitively rank these two assets according to moneyness.

To solve our problem we need independent moneyness markets. These sorts of markets would allow households, traders, and economists to strip out the moneyness properties of an asset in order to price that property and rank it. Incidentally, that's the same conclusion I arrived at in last week's post about the fundamental valuation of equities. If we could strip out the liquidity value of equities, we could better analyze and price the real yield provided by a stock. But more on this topic later.

Friday, March 15, 2013

One of the ironies of the stock market is the emphasis on activity. Brokers, using terms such as "marketability" and "liquidity," sing the praises of companies with high share turnover . . . but investors should understand that what is good for the croupier is not good for the customer. A hyperactive stock market is the pick pocket of enterprise. - Buffett

Our favorite holding period is forever - Buffett

While Warren Buffett may not be fond of marketability, liquidity or short holding periods, the fact that stocks have moneyness—that they have varying degrees of liquidity—is vital to understanding stock prices. In this post I'll show why analysts can't ignore the liquidity factor when they try to evaluate whether today's S&P500 is over or undervalued.

With equity markets setting new highs by the day, the chorus of fundamental analysts shrieking "overvalued" is deafening. These analysts often buttress their point by an appeal to some sort of benchmark valuation metric, like Robert Shiller's cyclically adjusted price to earnings (CAPE) ratio. The "cyclical adjustment" bit refers to the fact that the divisor, earnings, has been smoothed over several cycles, in this case the last ten year's monthly earnings.

The average CAPE since 1881 has been about 16.5x. Today we are currently paying a hefty 22.9x for each dollar of cyclically-adjusted earnings. In order to return to the long run average of 16.5x, the S&P500 would have to plunge by around 28%. That's quite the bear market.

In the chart below I've flipped the cyclically adjusted P/E ratio upside down into an E/P ratio, or a measure of the S&P500's earnings yield. The earnings yield indicates what sort of cyclically-adjusted fundamental return investors might reasonably expect for each dollar they invest in the stock market. The yield currently clocks in at 4.4%, far below the historical median of 7.1%, and way lower than some of the more juicy returns of 10-15%.

The point that fundamental analysts take from this chart is this: why invest in stocks if they don't yield anything close to their long term average?

Adding liquidity to the valuation equation

The fundamental analyst's appeal to Shiller's CAPE ignores the fact that a stock yields not just a pecuniary earnings return, but also a non-pecuniary liquidity return. Stocks are moneylike—put differently, they have moneyness. This feature is valuable. The knowledge that a given good or asset will be relatively easy to sell in the future provides its owner with a degree of comfort. After all, if something unexpected happens to the owner—a tree falls on his house—he'll be able to quickly exchange away those liquid assets in order to get started on home repairs. Less liquid assets don't provide the same level of comfort. Their owner can never be sure that they'll be able to easily sell them should a tree fall, or a storm hit, or a car crash. Assets with higher degrees of moneyness provide greater discounted flows of comfort over time.

Because liquidity is a valuable property, any asset's return should be broken down into the pecuniary returns it provides (dividends + appreciation) and a liquidity return. The higher the liquidity return that an asset provides, the smaller the pecuniary return it need promise potential investors. For example, even though the pecuniary return on Federal Reserve notes is negative (ie. the market expects slow and steady inflation), people still hold notes because their liquidity return is so high. Or consider the difference between savings and chequing deposits. A savings deposit is frozen for a period of time whereas a chequing deposit is easily transferred. To compensate investors for foregoing the liquidity of chequing deposits, savings deposits need to provide higher pecuniary returns in the form of interest.

How high is a typical stock's liquidity return? Unfortunately I can't tell you since the ability to back out a stock's liquidity return from its overall return doesn't exist. While I won't hazard a guess about the current liquidity return on stocks, I'm pretty sure I know its shape over time. Due to institutional innovation, a modern stock's liquidity return is *far higher* than it was in the past. Put differently, stocks are more moneylike than ever.

Because they have been honed to provide ever higher liquidity returns, a modern day stock simply does not need to provide the investor with the same cyclically adjusted E/P yield that it did in the 1950s or 1960s. Just like a chequing deposit doesn't need to provide the same return as a savings deposit, today's stocks don't need to provide as much per-share earnings potential as yesterday's stock. This means that you should be very careful about mining Shiller's long term data for clues about present-day valuation since you'll be effectively comparing apples to oranges or, more correctly, illiquid shares to liquid shares.

Institutional changes increase the ease of transacting in shares

Here is a list of ways in which equity markets have evolved over time to increase the moneyness of equities.

1. Falling fees: Prior to 1975, the NYSE required that all members set minimum commission rates. Competitive pressures from over-the-counter exchanges (along with SEC pressure) finally convinced the NYSE board to deregulate commissions in 1975, the famous Mayday episode. In Canada, the changeover date was 1983. As the chart below shows, commissions plunged.

Figure from A Century of Stock Market Liquidity and Trading Costs - Jones (2002)

In addition to lower commissions, the emergence of competing exchanges like NASDAQ in 1971, and, more recently BATS, Direct Edge, and various dark pools, have led to ever lower exchange trading fees. Lower fees make it easier to get in and out of stock, rendering stock more useful as exchange media. A direct result of Mayday, for instance, was Charles Schwab and the discount brokerage boom, a phenomenon which dramatically increased the pool of investors and deepened liquidity in equity markets.

2. Collapsing bid-ask spreads: The influx of high-frequency traders has dramatically compressed the average spread between a stock's bid and ask price. But even before then, bid-ask spreads had been on a long term decline:

Figure from A Century of Stock Market Liquidity and Trading Costs - Jones (2002)

New practices like decimalization, implemented in Canada in 1996 and the US in 2001, have contributed to spread shrinkage. Stocks used to be quoted in eighths of a dollar. This was changed to sixteenths in 1997, but the practice of quoting in narrower fractions only meant that the minimum spread was now 6.25 cents rather than 12.5 cents. Decimalization allowed the spread in liquid stocks like MSFT to shrink to a cent or two. We're even seeing sub penny spreads these days, an impossibility just two decades ago.

Like lower commissions, narrower spreads make it easier to transact, therefore increasing the moneyness of stock.

3. Back-office changes: In the old days, stocks were traded in certificate form. When stock was exchanged, brokers employed "runners" to carry certificates from one broker to the other. In the late 1960s, to deal with backlogs, certificates began to be immobilized at central repositories. All trades were transferred by book entry, a far easier process than before. Nowadays, certificates are being dematerialized, meaning that they are being converted into digital form. All this makes trade in stock safer, more convenient, and cheaper.

In the 1930s, the convention was to settle stock trades five days after trade day, or T+5. We are now at T+3 and moving to T+1, or straight-through processing. Again, the trade process is speeding up.

4. Standardization and transparency: The increasing adoption of universal accounting standards and practices have increased the quantity, quality, and comparability of information emitted by public issuers. Investor relations departments of listed firms are far more concerned than in times past about the equitable distribution of information. Insider trading, while illegal in the US since 1934, has become increasingly frowned upon in practice. Equity research has become more formalized, ensuring that information is more efficiently processed.

As a result of all these changes, the perception (if not the reality) exists that the stock market is no longer the loaded game of yore, when investors were typically pitted against a clique of operators with inside information and tight control of a company's float. Rather, the modern day stock market offers a flat playing field. This homogeneity and verifiability has set the stage for stocks to become more moneylike.

5. Longer trading days: The NYSE used to open at 10 a.m. and close at 3 p.m, an easy five hour trading window. While the Exchange also opened on Saturday morning, the window was only for two-hours, a practice that ended in 1952. Nowadays, NYSE ARCA, the NYSE's electronic trading platform, opens at 4:00 AM and closes at 8:00 PM.

Due in part to all these changes, share velocity has exploded. Put differently, the average holding times of NYSE stock has plunged from 8 years in the 1960s to around 12 months today:

Liquidity-adjusted fundamental analysis

Fundamental analysts, who frame investment decisions as if they'll own a stock forever, dislike this trend. To them, the equity market's increase in velocity, combined with a 23x PE ratio, represents a maddening increase in silly speculation. All they can do is sit on the sidelines and snipe.

On the contrary, the rapid increase in share velocity isn't silly, it simply reflects the market's growing willingness to treat stock like cash on the back of constant institutional innovation. Cash is useful because it is liquid and can get you out of a bind. Same with modern-day stock. Rather than treat high PE ratios and the increasing velocity of stock as products of irrationality, fundamental analysts need to understand that the premium put on liquidity is the market's reward for a very real transactional service provided by stock. What should fundamental analysts do? Stop trying to figure out if a stock is overvalued or not. Rather, try and find out if that portion of a stock's value not attributable to liquidity is overvalued or not. Or, put differently, try to strip out the liquidity return provided by a stock in order to focus purely on the real return. This amounts to calculating a liquidity-adjusted CAPE. But that's a post better left for next month!

Summing up...

A stock today is not your grandfather's stock. Stock can do more moneyish and cashlike things. It can be exchanged faster, safer, and cheaper. Because such a large chunk of a modern stock's returns now arise from their moneyness, fundamental analysts shouldn't be using earnings yields from the 1900s, let alone the 1800s, as a baseline for estimating modern yields. As long as the decades-long process of liquefying stock continues, it's very likely that the market will never again require stock to provide 7.1% returns. Today's 4.4% yield might be more normal than most think.

Tuesday, March 12, 2013

Well this is interesting. A bitcoin "fork" has emerged. I'm watching right now as the price of bitcoin on the Mt-Gox exchange plunges from $48 down to $37 or so, and now back up to $45. My guess is that the fork will be pretty much resolved before I wake up tomorrow—if not the mechanics, at least the optics.

What's a fork? I like to think of bitcoin as a publicly distributed ledger. Anyone who owns a bitcoin has a spot in that ledger. The ledger is in turn updated every ten or so minutes to account for new transactions. Updating occurs in a decentralized manner. Competing "miners" work to add batches of recent transactions to the ledger by solving a complex problem. The winning miner earns some bitcoins while all the the other miners double check to verify that the block of transactions submitted by the winner are real and sync with the existing ledger.

This all works fine as long as there are enough competing miners working to verify the process. If one miner, or group of miners, gets too large, they might collude to fork the ledger, adding false transactions to the original. Other participants may stay loyal to the original, resulting in two different ledgers.

The bitcoin ledger was forked tonight because of a technical error, not collusion. Incompatibilities arising from a changeover in Bitcoin versions was at fault, according to this source, with some users using the older version and others using the newer. Nevertheless, the price of bitcoin fell 24% in two hours (it took the Dow eight hours to fall 23% in 1987).

One of the deep problems facing the euro over the last three years was fear of euro break up. If Greece decided to leave the euro (or was kicked out), a Greek euro would no longer be equal a German one. In the mind of the markets, euros had ceased to be homogeneous. In anticipation of potential break up, a tremendous bank run began in which massive amounts of Italian, Greek, Irish, Spanish, and Portuguese euro deposits were converted into German and Dutch euro deposits. This all occurred on the books of the ECB's intra-eurosystem clearing mechanism—Target2. While no limits had ever been placed on Target2 balances (or imbalances), fears that Germans might revolt and try to close the Target2 window led to ever faster withdrawals from the GIIPS.

Much like heterogeneous euros, tonight's fork means that bitcoin transactors can't be sure if their bitcoin belong to the older or the newer version of the ledger. Are they guaranteed that the two will be fungible? Given this uncertainty, a bank run quickly developed. Except rather than a euro-style intra-bitcoin migration, everyone headed off to Mt-Gox and tried to buy USD as quick as possible.

Mario Draghi pretty much stopped the intra-euro bank run by pledging to ensure that euros would always be convertible at par. (See Gavyn Davies here & here). Likewise, the bitcoin developers are quickly moving to resolve the bitcoin run by ensuring that the fork is folded back into the original ledger. Both incidents serve as reminders that there is no such homogeneous entity as "money". The sudden realization of this on the part of the public leads to panics. Those maintaining payments networks need to immediately patch any threat of heterogeneity lest those panics become crises.

Monday, March 11, 2013

In you were living in Canada between 1870 and 1880 there's a good change that you might have held in your wallet the odd beast that was the private $7 note pictured above. Below is a $6 note issued by Banque Nationale in 1870, a bank that continues to operate in Canada today.

The first striking aspect of the $7 note is that the issuer is Molsons, the very same Molsons that brews one of Canada's best selling beers. Molsons Bank would eventually merge itself with the Bank of Montreal in the 1920s.

Going back a bit in history, the brand name on these notes isn't so unusual. Most Canadians are probably not aware that the entrance of the Bank of Canada into the business of issuing paper money is relatively new. Established in 1935, the BoC has only been a money printer for 78 or so years. Private Canadian chartered banks, on the other hand, began to issue paper banknotes as early as 1819. Until they gave up their right to issue notes in 1935, these banks had been continuously issuing notes for some 125 years. So Molsons notes aren't an anomaly—if anything, they've been the norm up here in Canada, it's the BoC that's a bit weird.

So why would anyone want a $7 note? Why not just carry one $5 and two $1s?

First, we should note that issuing banknotes is a cost-effective way for an institution to fund itself. Why? Notes don't pay out interest. In comparison, bond or deposit funding are pricier funding alternatives since interest must be paid on outstanding obligations. Fierce competition emerged among early Canadian banks to see who could keep their notes in circulation and "enjoy the float". The float refers to seigniorage, or the difference between the cost of maintaining banknotes in circulation and the interest that can be earned by investing note proceeds.

While the Canadian government no doubt wanted to share in this interest-free financing, a proposal by Lord Sydenham in 1841 to end the private issue of notes and monopolize issuance at a central bank never got off the ground. The next effort to move into the business of note issuance did get traction. But rather than establish a monopoly central bank, the Provincial Notes Act of 1866 only allowed for the issuance of $8 million in Province of Canada Notes. These instruments would later come to be known as Dominion notes. Much like US greenbacks, Dominion notes were direct obligations of the government, not of a central bank, and they circulated in competition with the notes of private banks.

Having gained for itself a toe-hold in the banknote issuance business, the Canadian government proceeded to shoehorn its way into a more dominant position. In 1870, the Feds required banks to surrender the issuance of small notes, or any denomination below $4.

Without the ability to issue $1s and $2s, chartered banks could not legally provide the public with hand-to-hand payment media to facilitate transactions that totaled $6, $7, or $11, and made it inconvenient to reach amounts like $26, $32, etc. The response of the Canadian banks was rather cheeky—they decided to print out $6s and $7s ($4 notes already being widely used in Canada). These new denominations allowed a bank to provide its clients with convenient payment media sufficient to total any transaction that clients might incur. An outstanding debt of $26, for instance, could be settled with one $20 note and a $6 note rather than one $10 and four $4s.

In 1880 legislation was passed that raised minimum private denominations to $5 and only permitted multiples of five. Thus ended ten years of oddly-denominated Canadian private notes. From that point on, only $1 and $2 denominated Dominion notes could provide Canadians with the flexibility to meet odd payment amounts.

Canadian $6 and $7 are an early example of regulatory-inspired financial innovation. No doubt the clamping down on private $1s and $2s was justified at the time by an appeal to Adam Smith's Wealth of Nations. While Smith usually advocated the free-banking position, he favored banning notes in denominations below £5. Small denominations were typically used by poorer classes whose ability to monitor notes for credit quality might be less than adequate. Without proper due diligence, wrote Smith, issuers of these notes would be able to overissue and cause credit booms and busts, hurting those least able to afford it.

I don't know what portion of the Canadian government's motivation for pushing into the banknote business emerged from the regulator-as-wise-outsider view and what portion from regulator-as-profit-seeking-monopolist view. But it makes me wonder how much of modern banking regulation is motivated by well-reasoned economic thinking and a genuine Smithian concern for the poor, and how much is motivated by interest groups co-opting the state to provide them with monopoly rents. Perhaps a bit of both. In any case, we shouldn't naively assume that bank regulation will solve all our financial woes.

Saturday, March 9, 2013

Here's a fun tool you can play around with. You may have to download the Flash player:

I made this chart back in 2009 but never quite finished it. A few days ago I decided to get 'er done, but when I opened the old document the dismal realization hit me that I had completely forgotten how to make charts in Adobe Flash. What a slog the last 46 hours have been. Anyways, enjoy.

The original is available here if you want to use it in your own posts, or if Blogger of Google Reader won't play it for you.

Thursday, March 7, 2013

There's been a steadyhumof articles that either worry about the Fed's potential QE-related capital losses or entirely discount them. Are central bank losses irrelevant or important? In this post I'll make the case that we should not discount losses as meaningless.

Let's say that year over year a central bank operates at a loss. It is unable to fund ongoing operations from cashflow, and to compound problems, the central bank is already operating with a bare bones staff and can't slim down.

One way to plug the funding gap is to get a capital injection. Who would do the injecting? The government, of course. This answer comes easily, since economists tend to build models that assume the consolidation of the government and its central bank. By tying them together with a nice red bow, the math and logic are made much simpler. Thus a central bank can easily run at a loss since it is really just a department within a larger consolidated entity.

Let's adopt the perspective of an investment analyst who has money on the line. Any investor knows that networks of parents and subsidiaries should never be treated as one entity. Parent companies often let subsidiaries hang out to dry, looting them of good assets and transferring bad ones in, or refusing to commit capital for the maintenance of a subsidiary's plant and equipment in order to allocate capital back to the mothership. Parents purposefully damage certain subsidiaries so as to maximize the overall welfare of the group. Those who suffer are minority shareholders and bondholders of the damaged subsidiaries... and that's why wise minority investors never make the mistake of assuming their interests are consolidated with those of the parent.

Just as parent-subsidiary relationships can be tenuous, there's no reason for investors expect the existence of a 100% guarantee of government support for its central bank. Minority investors in the Fed—anyone who holds Fed paper and deposits—must always be wary of the possibility of either being looted or being left to hung out to dry by the sovereign.

How plausible is this deconsolidated view? We in the West tend to look at everything with Fed or ECB-tinted glasses, but there are more than a hundred central banks in our world. Consider the case of the Central Bank of Philippines (CBP), for instance. According to Lamberte (2002), the CBP was harnessed by the government in the 1980s to engage in off-balance sheet lending and to assume the liabilities of various government-controlled and private companies. All of this was to the benefit of the government as it lowered the deficit and kept spending off-budget. Later on these loans proved to be worthless, leaving the central bank holding the refuse. This has shades of Enron, which used various conduits and SPVs to hide its mounting losses.

The CBP was replaced in 1993 by the newly chartered Bangko Sentral ng Pilipinas (BSP). The BSP took over the CPB's note and deposit liabilities, as well as its foreign reserves and other valuable assets (the bad assets were allocated elsewhere). The government had promised to contribute 50 billion pesos in capital to the BSP, but only paid P10 billion in 1993. The remainder owed was not forthcoming. After some seventeen years, the government finally added another P10 billion in 2011, but this still leaves P30 billion in unfunded obligations to the central bank. The BSP has been left out in the cold by its parent.

So who cares if the government refuses to inject capital into a loss-making central bank? How could that possible have any macro effect?

Well, if a central bank can't fund itself from operations, nor by financing, then it needs to sell its own assets to raise cash. So it starts selling off a few bonds here and there, using the proceeds to pay the governor's salary. Or maybe it prints off a few fresh dollars and uses those to pay staff.

As I've pointed out before, one feature of a central bank is that blowfish-like, it can suck in all of the liabilities it has issued by redeeming them for assets. This potential for redemption is one of the key forces that props up the value of central bank paper. Without it, dollars and pounds would be mere paper bits of paper. The ability to suck in and blow out liabilities is also essential to monetary policy, in particular the maintenance of price stability. Central banks use open-market purchases and sales of assets to enforce their inflation targets.

If it sells too many assets to fund itself, or prints to much cash to pay salaries, the central bank's ability to act like a blowfish and suck in its outstanding liabilities is inhibited. To compensate investors for the increased risks of non-redemption arising from central bank losses, central bank notes and deposits need to offer a higher return. This return manifests itself by a quick fall in the purchasing power of money, or inflation. From this much lower plateau, the value of central bank's liabilities will be expected to appreciate, thereby providing enough capital gains to compensate investors for increased redemption risk. But this threatens the central banks price stability targets and breeds a general lack of faith in the central bank's power. Central bank losses can have consequences.

This interesting bit from the Bangko Sentral ng Pilipinas's 2011 Annual Report captures these ideas. The bank is commenting on the losses it experienced in 2011:

Because its mandate is typically specified as the maintenance of price and financial stability, a central bank is tasked to stabilize the economy in the presence of macroeconomic shocks. Such stabilization efforts typically involve costs to the central bank... In this regard, the full capitalization of the BSP is being pursued to allow the BSP to operate fully without being constrained by balance sheet weaknesses or operating losses... The full capitalization of the BSP needs to be ensured to enhance the viability and credibility of its various policy tools. It may be noted that a central bank’s sound capitalization is critical for the effective pursuit of its mandate as well as for political economy and credibility considerations.

In sum, the threat of central bank losses isn't something that can be glossed over. There is never a 100% guarantee that a parent government will recapitalize its central bank, which means that a central bank could be forced to dilute its asset base in order to fund operations, inhibiting its ability to ensure price stability.
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PS: Funny enough, as I was writing this, David Andolfatto posted on this topic yesterday. Here is David:

In many of our models, we assume passive support from the Treasury to support whatever needs to be done to keep inflation in check. But how realistic is this? What if that support does not materialize? And moreover, suppose that the Fed is no longer permitted to use IOR as a policy tool? What if inflation and inflation expectations start to rise? What then?

In questioning the consolidated Fed-Treasury entity, I think David and me are saying roughly the same thing.

Tuesday, March 5, 2013

Over at the Free Banking blog, Kurt Schuler has twogood posts on where to draw the line between money and other assets. While Schuler likes to differentiate between the monetary base (deposits at the central bank + currency) and other assets, he points out that there are a number of other popular spots to scratch out a line. The monetarists, for instance, settled on M2. I seem to recall that in America's Great Depression, Murray Rothbard let the cash surrender value of life insurance policies slip over the line into money supply territory. There are a thousand-and-one places to draw the line.

Schuler notes that rather than drawing a sharp line between money and other assets, one can also recognize a spectrum of "moneyness." Anyone who's read this blog knows that I'm amenable to this idea. Before we can ask where do we draw the line? we need to ask how do we draw the line?. Either treat money as a set of distinct goods, or treat each good as more or less money-like. By money-like, I'm referring to a good's role as a medium-of-exchange, not its role as a store-of-value or unit-of-account.

I've tried to convey these two approaches in the graphic below. I don't think either approach is better than the other, but we should be consistent. Depending which one you choose, you'll probably be able to see the economy from a different perspective, and different perspectives can be helpful.

Rothbard and the monetarists took the first approach. Between which discrete goods should the line be drawn? Should bank deposits make it past the line or not? How about shares?

Rather than placing a line between discrete groups of goods, the second approach draws a unique line across each individual good. This line demarcates each good's monetary qualities from its non-monetary qualities. All goods are money, but some are more money-like than others. Cattle (i.e. commodities), for instance, are simultaneously capital/consumption goods while also having monetary properties. Even beer (consumer goods) has a degree of moneyness since specialized producers, wholesalers, and retailers hold bottles in inventory for the purposes of resale.

In his discussion of moneyness, Schuler invokes the same classic 1956 W.H. Hutt paper that I've mentioned before. According to Hutt, money throws off a constant stream of services, the essence of which is availability. Just as an unused fire extinguisher provides its owner with constant comfort, the availability of money in one's wallet provides a steady flow of relief. Hutt described this idea as the yield from money held. But Hutt's is still an expression of absolute money, not moneyness, for his choice of words implies that only money-proper yields availability services and all other goods be damned. I find it useful to convert Hutt's expression from one of absolutes to one of degrees by rephrasing it as the money-yield from goods held. Beer, cattle, houses, stocks, banknotes, and bank deposits all throw off availability services, though the size of this stream varies according to each good's marketability, or liquidity. Because this service is valuable, a premium gets built into the price of a given good, or a liquidity premium.

Continuing his discussion of moneyness, Schuler also brings up the Divisia index, a technique of aggregating monetary assets championed by William Barnett. Rather than simply summing up quantities of so-called money, a Divisia index is a weighted monetary index. A component's contribution to the index is determined (in part) by its degree of monetary usefulness. How are monetary services computed? A liquid asset's interest rate is compared to the rate yielded by an illiquid zero risk benchmark bond. The more interest that is foregone in holding the given liquid asset implies that larger monetary services are being offered to compensate the asset holder. In other words, the lower its interest rate, the more money-like the asset, and the larger a component's contribution to the Divisia index.

This is a fascinating approach. Theoretically, I'd go even further than Barnett in extending the continuum of moneyness beyond financial assets to stocks, houses, cows, and beer. Here the computations get difficult. Barnett uses market-determined interest rates from debt markets to determine each Divisia component's monetary services. But the return from a stock comes primarily in the form of expected capital appreciation, not interest, so teasing out a stock's monetary services by comparing it to some illiquid interest-yielding benchmark bond would probably prove to be difficult. The same goes for houses, and it gets harder to compute moneyness the further we wade into markets for commodities and goods.

Even if we arrive at some aggregate amount of money services, I'm not yet sure what it would be useful for, and for whom. In thinking about degrees of moneyness, my preferred application would be liquidity spreads rather than liquidity aggregates. Being able to see the risk premium of a given asset via credit default swaps is certainly useful, at least to financial market participants. One would imagine that knowing an asset's liquidity premium—how that premium fluctuates over time and how it compares to other assets' premia—would be just as helpful as knowing its risk premium.

Sunday, March 3, 2013

One of the world's newest monies has been born. A cryptocurrency (these seem to be coming out every week), our new unit goes by the currency code XRP. What makes this even more interesting is that XRP is a chartal currency. Unlike commodity monies, chartal currencies are intrinsically worthless. The only reason they have a positive market value is because people must get their hands on them in order to pay taxes. Just so with XRP—people must pay their "Ripple taxes" with XRP. But more on that later.

XRP and Ripple go hand-in-hand. I wrote about Ripple last week. Ripple is an online environment which allows individuals to exchange IOUs denominated in bitcoin, US$, ₤, or any other unit of account. I'm not going to go into more depth on Ripple but if you're interested, click through last week's post or read this very well-written article from Bitcoin Magazine.

What is interesting is that in order to make use of the Ripple environment, Ripple developers have required that users procure tokens, or XRPs, ahead of time. First, to open a Ripple account, users must deposit 200 XRP as a reserve. Second, in order to extend a line of credit to another Rippler, users need to deposit an additional 50 XRP as reserve. Lastly, to carry out a transaction, 0.000001 XRP must be paid. (While this 0.000001 XRP is destroyed forever, XRP held as reserves are simply released once the account is closed or line of credit withdrawn.)

Much like a sovereign issuer of chartal units, the creators of XRP (the "government") must first spend XRP into the economy so that members of the system are able to pay their Ripple XRP dues (or "taxes"). One hundred billion XRPs have been created, with the founders of Ripple getting twenty billion before distributing the remaining eighty billion to OpenCoin, the organization that will be developing the Ripple system. Potential Ripple users have had wait for OpenCoin to "spend" XRP into the economy before they could begin to use the Ripple system. The first emission was in the form of a free gifting of 50,000 XRP to anyone interested beginning two weeks ago.

Since the initial gifting, XRPs have begun to be traded on secondary markets where they are being priced at around 45,000 XRPs to 1 bitcoin (~1,300 XRP to the US$). Note how well this jives with the chartal idea that the positive value of a fiat token arises because of the obligation members have to pay their dues with that token. Just like chartal tokens are used for more than just tax payments, businesses are agreeing to accept XRP for non-Ripple related transactions.

Most cryptocurrencies, including bitcoin, litecoin, devcoin are bootstrap currencies. To earn a non-zero value, they've paradoxically had to pull themselves up by their bootstraps. No outside institution has given bitcoin or litecoin a helping hand by requiring either as a prerequisite for consummating transactions. Bootstrap currencies are highly unstable—while they've picked themselves up off the ground by pulling on their own bootstraps, they can just as easily lose grip of their bootsraps and crash back to zero.
The demand for XRP, on the other hand, is underpinned by the necessity of using them to pay Ripple dues.
This demand anchors XRP's price to the downside.

You'll notice that one traditional element of chartalism is missing here: the state-nature of chartal money. Opencoin and Ripple are private institutions... and yet they have created a chartal currency. It would seem that there is nothing in the idea of chartal currencies that requires the state. (I made this same point in an older post.)

When Somalia collapsed into civil war in January 1991, the doors of the Central Bank of Somalia were blown apart, its safes were blasted, and all cash and valuables were looted.* But something odd happened—Somali shilling banknotes continued to circulate among Somalians. To this day orphaned paper shillings are used in small transactions, despite the absence of any sort of central monetary authority.

The strange case of circulating Somali shillings forces us to ask some fundamental questions about money. If the Federal Reserve and all other branches of the US government were to be suddenly swallowed up into the sea, would Fed banknotes, like Somali shillings, continue to be used? What forces conspire to keep coloured squares of paper in circulation when their original issuer has long since expired?

According to Luther & White (2011), the shillings' continued circulation within the context of a collapsed state casts doubt on the universality of the chartal theory of money. According to chartal theory, the requirement that people pay taxes with government-issued bits of paper is what drives the positive value of these bits. Since a world with no state is a world with no taxes, the continued use of shillings means that something other than tax acceptance must be driving their positive value. [As an aside, I'd note that the ongoing circulation of bitcoin also contradicts the taxes-only theory of chartal money. After all, bitcoin isn't used to pay taxes, it's used to avoid taxes].

Luther & White give what seems to me to be a very Misesian explanation for the shilling's continued positive value: the "inertia of historical acceptance". According to Ludwig von Mises's regression theorem, outlined in Theory of Money and Credit (1912), people's expectations about the value of bits of paper may "regress" into the past. An intrinsically useless bit of paper is valued today because it had a positive value yesterday, and it had a positive value yesterday because it did the day before, all the way back to day 1 when that useless bit of paper was anchored to some commodity.

This process is described as a coordination game in Luther & White. Though the central bank had collapsed in January 1991, a Somalian trader might choose to still accept shillings the day after the collapse because he had accepted them the day before and he knew that others had accepted them too. In a self conscious manner, the trader would also know that other traders knew that he had accepted them. Expectations about expectations about expectations, a Keynesian beauty contest of sorts, was sufficient to drive the use of shillings beyond the day of the central bank's demise.

Counterfeit notes and contingent redemption

Let's add some more texture to our example. Not only did old shillings continue to circulate, but several new issues of counterfeit notes joined them. These counterfeit 1000 and 500 shilling banknotes were created by warlords and businessmen subsequent to the country's collapse. Although the counterfeit notes had the same design as the pre-1991 legacy notes, small differences allowed for differentiation. According to Luther (2012), of the five known forged issues, four have the date 1996 printed on them, long after the central bank ceased to exist. The counterfeits dated 1996 are signed by central bank governor Ali Abdi Amalow who, having been appointed in 1990, had never held office long enough to have his signature affixed to genuine Somali notes. Even without these imperfections, fake banknotes would have been instantly recognizable to anyone—they would have been crisp and clean relative to the limp and dirty legacy issue.

Despite being easily differentiable, Somalians willingly accepted counterfeit 1000 and 500 shilling notes. Not only did they accept them, they considered them to be fungible with real 1000s and 500s. In other words, the market refused to place a discount on the fakes.

Mubarak (2003) offers a few reasons for the acceptance of counterfeits. Any reticence the public may have had concerning the legitimacy of counterfeit note was overcome by A) coercion on the part of issuing warlord; B) a financial inducement to accept new notes including an initial 5% discount to the price of legacy notes, and C) the claim that new notes were liabilities of the Central Bank of Somalia. According to Mubarak the latter instilled a "general public belief that the forged... banknotes must eventually be upheld and honoured when effective national government comes to power."

This last detail is interesting because it might explain not only why counterfeits were accepted, but also why legacy Somali banknotes continued to circulate after the Somali state collapsed. Upon the eventual reconstitution of the Somalian state, a new central bank would most likely be created. This newly recapitalized Central Bank of Somalia would hold a stock of assets funded, say, by the IMF. The central bank might take upon itself the original central bank's note liability No longer orphans, old banknotes could now be convertible into deposits held at the new central bank and, insofar as the central bank targeted inflation via open market operations, these deposits would in turn be convertible into genuine backing assets.

Thus the promise of redemption by a not-yet existing central bank may have been enough to give present shillings, both genuine and counterfeit, a positive value.

This means that any changes in the purchasing power of shillings might be due not only to variations in the quantity of outstanding Somali media-of-exchange. Reassessments of the probability of a central bank both being created and honouring the previous note issue would also affect their purchasing power. For instance, should the Transitional Federal Government, a government in-waiting of sorts, succeed in consolidating its position in Somalia by winning a key battle, the odds of redeemability would increase, as would the value of shillings.

Historically orphaned currencies

This tension between fiat-paper-as-redeemabale-financial-asset and fiat-paper-as-medium-of-exchange is an old one. It was at the centre of one of the greatest monetary debates of the 19th and early 20th century, a dustup that involved luminaries like Irving Fisher, Knut Wicksell, Laurence Laughlin, Benjamin Anderson, Ralph Hawtrey, and Ludwig von Mises. The discussion centered on the irredeemability of US Greenbacks.**

Greenbacks, which had been issued in 1861 to pay for the Union Government's expenses, were initially 100% redeemable in specie. The redemption clause was suspended later that year and subsequent issues of greenbacks didn't even claim to be convertible into gold. Greenbacks quickly fell to a large discount relative to the metal. By August 1864 the discount had hit its widest point as the paper traded at 38 cents on the gold dollar.***

As with Somali shillings, economists were curious about these seemingly-orphaned liabilities. Why were greenbacks still accepted? What governed their value? Wicksell, Mises, and Hawtrey held that if there is a demand for the medium-of-exchange as such, this demand would be sufficient to give value to whatever instrument was established by custom as the medium-of-exchange. Thus the continued acceptance of greenbacks at positive values was mostly due their already-favorable marketability.

Countering this panel of illustrious economists was J. Laurence Laughlin. Though Laughlin doesn't attract the same brand recognition as do these other long-dead economists, in his day he was considered to be America's leading monetary economist. In his book The Principles of Money (1903), Laughlin outlined the view that greenbacks should be treated like non-dividend paying common stock. Just as a stock might have some positive value now due to potential dividends several years down the road, the continued positive valuation of greenbacks was due entirely to the possibility of their future redemption.

To illustrate his point, Laughlin drew attention to the market's reaction upon the success of the Union Goverment in the Battles of Gettysberg and Vicksburg. After these battles the greenback's discount to gold dramatically narrowed, presumably because these victories were perceived by the market as increasing the probability of future redemption of greenbacks in specie. Laughlin also mentions the passage of the Redemption Act of 1875, in which the government declared its intention to redeem all greenbacks come January 1, 1879. Though still trading at a discount to gold, greenbacks began to steadily appreciate towards par as this date approached, just like a t-bill approaching maturity. Thus Laughlin's redemption theory held up nicely to the evidence.

While Wicksell described Laughlin's theory as "perverse and fantastic," it was hard for Mises, Hawtrey, or Wicksell to deny that the expectation of future redemption didn't have at least some effect on greenback's value. In his book the Value of Money (1917), Benjamin Anderson struck a middle ground between all parties. Anderson held that Laughlin was right to treat greenbacks like any other asset whose value was dependent on eventual redeemability. But Anderson also thought that Mises and the rest were correct to put an emphasis on greenback's unique monetary function. Anderson combined these views by illustrating how greenback's "money-use" would be captured by the market as an extra bit of ascribed value on top of redemption value, or a liquidity premium.

Just to make things more complicated: New Somali Shillings

Back to the Somali shilling. The last feature of the Somalian monetary economy that I find interesting is the presence of yet another media of exchange
—
the "New Somali Shilling".**** Just prior to the January 1991 collapse, Somalia had been experiencing accelerating inflation. The Somali government drew up plans to replace existing shillings with the New Somali shillings. Each New Shilling was to be worth 100 old shillings, and notes were to be printed in 20 and 50 shilling denominations

According to Symes (2006), the first shipment of New Shillings arrived in Somalia several months after the collapse of the state. Ali Mahdi Muhammed, a factional leader in Mogadishu, seized several billion of these official New Shillings and spent them into the economy in November 1991. While New Shillings did gain acceptance, their use was limited to a small area in North Mogadishu—the area controlled by Ali Mahdi Muhammed. Nor were they fungible with the legacy notes. 500 worth of New Shillings, for instance, was not worth 500 worth of old shillings. Nor did New Shillings circulate at the pre-1991 intended value of 100 old shillings to one New Shilling. At the time of Mubarak's article, a New shilling was worth only a third of an old shilling.

This challenges Luther & White's theory that Somalians accepted shillings because of their previous experience with them. Why did Somalians accept New Shillings at all if they were not accustomed to doing so? Why not refuse and continue to trade in legacy shillings? Legacy shillings circulated in Mogadishu at the time, so traders would have presumably had a choice. Why take a bet on an untested currency?

New Shillings also challenge the Laughlin-esque theory that redemption underpins the positive value of fiat paper. If Somalians universally valued shillings because of their future redeemability, why would they not place a higher value on New Shillings relative to old? After all, according to its stated plan, the Central Bank of Somalia was willing to convert 100 old shillings into 1 New Shilling. If it was believed that a newly chartered central bank would take on the liability of Somalia's counterfeit notes, wouldn't that same central bank uphold a commitment to value New Shillings at a far higher rate than old ones? Why then do New Shillings trade a third the price of old shillings rather than at a multiple of 100?

As much as I dislike to leave more questions than answers, that's about all I can do for the time being. One major data point is yet to come. What actually happens to legacy and counterfeit notes when a new central bank begins to operate? The Central Bank of Somalia's website says this:

Towards fully assuming its functional and institutional responsibilities, the Bank has completed the reconstruction of its Headquarters in Mogadishu while the branch in Baidoa has been established and is already functioning with personnel in place.

Perhaps we don't have long to wait.
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*Abduraham in Luther (2012)**Debate also surrounded the irredeemability of Austrian gulder banknotes. The Revolution of May 1848 resulted in the withdrawal of the convertibility of Austrian gulden banknotes into silver. The discount on gulder notes relative to silver averaged around 15% for the first 10 years and then dipped to an average of 28% from 1859 to 1865. Laughlin pointed out that by the 1860s speculation began to grow that Austria would switch from the silver standard to a gold standard. If the banknotes, still irredeemable, were to be honoured, it became increasingly evident that redemption would be in gold, not silver. At the same time, large silver discoveries were driving down the value of silver relative to gold. As a result of these forces, the market value of notes rose back to par with silver. As the market became progressively more confident that the notes would be redeemed, and redemption would be in much more valuable gold, gulder notes eventually exceeded their stated silver value. Laughlin's theory seemed to be borne out by the facts--the value of orphaned notes was dictated by their future potential redeemability.*** From A History of the Greenbacks (1903), by Wesley Clair Mitchell**** Mubarak refers to this instrument as the Na' Shilling.